Econ 3545 Environmental Economics, University of Colorado, Fall 1998

Instructor: Vijaya Sharma, Ph. D.

Midterm 2 (Nov 4, 1998)

The test is worth 20 points. Attempt all ten questions. Each question carries equal weight. Be precise, no question should take more than few sentences to answer. GOOD LUCK!

1. Explain any two.

a. Representative firm approach of estimating costs of industry-wide environmental regulation

b. Dose-response relationship in the estimation of health damages from pollution

c. Nonuse value of environmental resources

2. How would you put monetary values on direct estimate of health damages from working in a polluted workplace?

3. Explain the wage differential method of estimating willingness to pay for reducing pollution in the workplace.

4. Which of the two estimates done above - direct estimate of health damages and wage differential estimate - would you choose as a better measure of benefits of reducing pollution in the workplace? Why?

5. Give three reasons why respondents in a contingent valuation survey are likely to misstate their willingness to pay for improvement in environmental quality?

6. Explain how you would treat the following items in the benefit-cost analysis of an environmental project.

(a) Taxes paid by the environmental project

(b) Land donated by an anonymous donor for the use of the project

(c) Minimum wage paid to unskilled labor engaged in construction of the project

(d) 100 jobs created by the project

7. Answer any two.

a. Distinguish between with/without principle and before/after principle of estimating costs of an environmental regulation.

b. Distinguish between efficiency and cost effectiveness.

c. Distinguish between emission standards and technology standards.

8. a. Suppose you have been entrusted by the Environmental Protection Agency to set emission standards. Also suppose that you have all necessary information available for this purpose. Which level of emissions would you specify as the standard? Show that standard in a MAC-MD graph.

b. Suppose you convince polluters that this standard is stable and that the standard would not change when they develop cheaper methods of complying with the standard. Does your standard offer incentives to innovate improved methods of pollution control? Explain with the help of a graph. It is important that you appropriately label the axes, the curves, and the relevant areas in the graph.

9. Define any two.

a. Exclusivity Characteristics of Efficient Property Rights System

b. Zero-risk Approach of Setting Emission Standards

c. Value of Statistical Life

10. State Coase theorem. Explain when assignment of private property rights over an environmental resource may not lead to efficient utilization of the resource.

Please return this test with your blue book.

Econ 3545 Environmental Economics, Fall 1998

Answer Key to Midterm 2 (Nov 5, 1998)

Note: although I have included additional clarifications to some answers, such clarifications are not necessary in answering the questions.

1. a. Representative firm approach is an approach used in estimating costs of an industry-wide regulation. When there are many firms in an industry, firms are categorized into relatively homogeneous groups by size or technology, and one representative firm is chosen from each category. Costs of regulation to each representative firm are estimated and extrapolated to the entire industry.

Additional clarification: Some students seem to have a notion that only one firm is chosen to represent the entire industry. This is an unnecessarily stringent approach, and it is hard to imagine that one single firm would be representative of the entire industry. If there are, say, 1000 firms in an industry, it is possible that they be grouped into 20 categories and, thus, there would be 20 representative firms, one for each category. It would be a lot cheaper to study 20 firms, instead of all 1000 firms, and 20 firms are likely to be more representative of the industry than one single firm.

1. b. Dose-response relationship is a relationship between physical quantities of emissions discharged and the type and extent of health damages (in physical terms) they cause.

Additional clarification: This kind of relationship is established by doctors, scientists, and technicians. Only when this relationship is available, economists can think about putting monetary values on health damages.

1. c. Nonuse value of environmental resource is independent of the extractive or recreational uses of the resource. This value is attributed to letting resource remain unused. Option value, stewardship value, etc. are some such types of nonuse value.

Additional clarification: Indirect methods cannot measure nonuse value, only contingent valuation method can estimate this value.

2. Direct estimate of health damages is done by adding up medical expenditures on recovering from health damages, wages lost due to sickness, and potential income lost due to premature death, if any.

3. Wage differential method of estimating WTP for reducing pollution in a workplace is based on the premise that workers have to be offered higher wages for them to be willing to work in a more polluted place. Higher wages would reflect workers= WTP for reducing pollution.

4. Wage differential method leads to a better estimate of benefits of reducing pollution because this estimate, unlike the direct estimate of damages, implicitly includes pain and suffering associated with sickness and any averting expenditures workers might undertake to minimize health damages. Direct estimate of health damages is only a lower bound, and understatement of benefits.

Additional clarification: Wage differential reflects not only medical expenditures, wage loss due to sickness, and potential income loss from premature death, it also reflects pain and suffering and averting expenditures. Suppose a polluted workplace offers $10,000 more annual wage, compared to otherwise similar but clean workplace. Workers who accepted the riskier job for $10,000 additional wage, must have thought that this amount at least compensates them for the following:

i. Any averting expenditures they might incur on minimization of health damages.

ii. Any additional medical expenditures to recover from health damages. Note that, in spite of averting expenditures, there may still be some health damages, and damages could be greater in the absence of averting expenditures.

iii. Any wage or income loss due to sickness or possibility of premature death.

iv. Any pain and suffering they will have to endure due to sickness.

Of course, we are assuming that workers have the knowledge and necessary information on the above expenditures to evaluate whether they should accept the job at the polluted workplace.

5. A respondent in a contingent valuation survey is likely to misstate his or her WTP for a number of reasons.

(A) Since the respondent has to put a value on a hypothetical product, the respondent may lack knowledge or information or simply may not know actual WTP.

(B) Even when the respondent knows his or her true WTP, there may not be a reason to reveal the true value. Most environmental improvements are public goods in nature, and respondents may choose to free ride.

(C) There is no direct link between the value put by the respondent and the cost of supplying the environmental improvement the respondent might be asked to share. Therefore, if the respondent wants the improvement to be implemented, the respondent may state a high WTP to ensure that benefits of improvement look high.

(D) If the respondent is an environmental activist or believes in greater cause of environmental protection, the respondent may embed the value of the greater cause into the specific improvement in question. Essentially, the respondent values a product different from the one being asked.

(E) Although respondent=s WTP may be zero or low, the respondent may put a higher value to simply look good to the interviewer.

6. a. For the environmental project, taxes are costs; but, to the society, they are simply transfer payments as these payments are not in lieu of use of resources or goods or services. You should exclude taxes from benefit-cost analysis.

6. b. Although land comes free to the environmental project, society has to give up alternative uses of land if it is used in the project. Therefore, you should include competitive market price of the land as a social cost in the benefit-cost analysis.

6. c. Minimum wages paid are monetary costs to the project; but, they do not reflect true cost, or true scarcity, of labor. The true costs to the society are the competitive wages of the labor employed in the project. Estimate and include competitive wages in the benefit-cost analysis.

6. d. Many times you hear argument that projects create job opportunities. Normally, these jobs come at the expense of other jobs in the economy, as labor employed in this project would have been employed elsewhere. Therefore, jobs creation is not a social benefit. Jobs creation can be considered a social benefit only when labor would remain unemployed in the absence of the project.

Additional clarification: Some students, in their answers, seem to imply that a monetary cost is not a social cost. A monetary cost (whether borne by a private or public entity) can be and mostly is a social cost. Monetary cost would not be a social cost only when either it is a transfer payment (like taxes) or it does not reflect competitive market prices (donation of land and minimum wage).

7. a. With/without principle estimates cost of a regulation for the same year once with the implementation of the regulation and once without the implementation of the regulation. In contrast, before/after principle compares costs incurred in the year before the implementation of the regulation with the costs incurred in the year after the implementation of the regulation.

7. b. Cost effectiveness means minimizing cost, or choosing the technology associated with the lowest MAC if there are alternative technologies available for pollution reduction. On the other hand, efficiency means both choosing the lowest MAC and balancing MAC with MD.

7. c. Emission standards are standards that polluters cannot exceed in terms of amount of emissions they discharge, irrespective of technology they use. On the other hand, technology standards are the mandated technologies polluters must use to comply with the standards.

8. a. Because you have all the necessary information, you should choose the efficient level of emissions as the emission standard. Show this in a graph as a point that balances MAC and MD.

8. b. If this emission standard is stable, polluters would gain by lowering MAC; therefore, the standard provides incentive for innovation of improved methods of pollution control. Draw a graph with MAC1 and MD and show the intersection of these two curves as your emission standard (say, e*). Now draw a MAC2 curve below MAC1. Then, the area bounded by MAC1, MAC2 and e*-vertical line is the area of potential saving of cost of abatement from innovation.

Additional clarification: Some students chose the intersection of MAC2 and MD as the specified standard. This would be a technology-forcing standard, as you are forcing the industry to develop and use MAC2 technology. Clearly, you are betting on the development of MAC2 technology. What would happen if the industry does not succeed in this innovation? Your standard is currently inefficient and would remain inefficient at least until the new technology is, or would ever be, developed. In addition, it is simply irrelevant to talk about incentives to innovation of a technology that you are forcing through legal sanctions.

9. a. Exclusivity characteristics refers to the condition that all benefits and costs associated with owning and using a resource goes to its owner and the owner only, directly or indirectly through sale of services of the resource.

9. b. Zero-risk approach is to set emission standards at the level of threshold of marginal damages, the point where emissions just start generating damages. In a graph, this is a point where MD intersects with the horizontal axis.

Additional clarification: Note that zero risk does not necessarily mean zero emissions. Under a zero-risk standard, emissions are allowed until they are likely to cause damages.

9. c. Value of statistical life is the value placed by the society on saving a life of a random individual, which could have been lost in the absence of environmental improvement being considered.

10. Coase theorem: if private property rights over an environmental resource are clearly defined, and bargaining between the owner and the prospective user is allowed, it would result into efficient utilization of the resource, irrespective of who is initially given the property rights.

Assignment of private property rights over an environmental resource may not lead to efficient utilization if there is a huge transaction cost involved in bargaining and finalizing agreement between owner and prospective user and/or if the resource has nonmarket benefits (i.e., exclusivity characteristics is lacking in the ownership).